Before we engage in explaining the formula, you need to know what the difference between a shareholder and a stakeholder is. A shareholder holds a part of the company through shares of stock and a stakeholder is interested in the performance of a company. With these being said, it’s time to explain what Return on Equity (RoE) really means.
Return on equity means that stakeholders that invest in a company should get the same amount back or more. Thus, this calculation is used by potential investors to see how the company uses their money to gain net income. It’s quite hard to understand, but the formula may shed some light on the words above.
Return on Equity Formula
The return on equity formula is quite basic. All you have to do is divide the net income to the shareholders’ equity, and you’ll get the return on equity result. So, the formula should look like this:
This formula is mainly used for all shareholders, so preferred dividends are not taken out of the net income. If you want to get the preferred dividends out for common shareholders, the formula will look like this:
If another shareholder appears, the best advice is to calculate the return on equity right away, so you can have an idea of what comes next and if the new shareholder makes any difference. If a shareholder leaves, you should do the math to see the potential loss, if any. It’s best to calculate common shareholders and for a shareholder at a time to see how much net income you can gain.
Understanding the Return on Equity Formula
With the above being stated, these calculations are specific for investors and not for companies, although companies may use them as well. Investors can see whether the money invested in the company is being put on the good use and generates income or not.
If a higher return on equity is registered, then the company is investing the money efficiently. The formula can also be employed by investors to see exactly what company is more suitable to invest in. However, you should be aware that the company must be in the same field of activity. All companies have a different return on equity ratios, thus calculating the RoE for an IT company and comparing it to a construction company is a bad idea.
Many investors calculate this ratio at the beginning and at the end of a period to see the chart flow. If a chart shows an ascending trend, then the money is invested correctly.
To conclude the above information, the return on equity formula is vital for every investor who wants to see the company getting net income from what they invest in. If the investment turns nothing, then the money invested is lost and a company will lose its notoriety, as well as its shareholders and stakeholders.